Importance of Expense Ratio in Mutual Funds

When investing in mutual funds, what is the smartest thing to do? Check the Expense Ratio! It is an annual fee mutual funds charge the investor for running and managing their money. The fee is inherent in all mutual funds and cannot be avoided completely as it’s swept from the final payout (principal & returns) to the investor. The thing with expense ratios is they compound over time which can have an impact on the investment corpus.Schemes with high expense ratios can drag down the value of the portfolio while those with minimal expenses can increase the take-home returns substantially. Not something to be shrugged off lightly right? Let’s delve deeper.

All mutual funds have an expense ratio. It refers to the annual charge levied by asset management companies (AMCs) to cover expenses for operating the fund. A small percentage is deducted from the investors’ total assets each fiscal year for various operating expenses which get reflected in the scheme’s expense ratio. These include costs incurred for administrative services, allocation, management, communication, legal matters, custodian fees, and marketing, to name a few.The expense ratio has an inverse relationship with the size of the mutual fund. Low Assets Under Management (AUM) increases the expense ratio as the costs mentioned above have to be met from a limited asset base. Whereas, if the resources are sizeable, the relative value of expenses diminishes because they stretch across a wider base.

Mutual funds charge investor’s a fee to covers the expenses for running the show. Many costs are included in the scheme’s expense ratio, but there are three major types. These are the following:

• Management fees To ensure smooth functioning and seamless performance, mutual funds have onboard a proficient team of fund and portfolio managers. They are entrusted with the responsibility to carry out intensive research and formulate investment strategies that will generate good returns. AMCs pay the management fee to the professionals as compensation for handling the funds flawlessly on their behalf. Management fee comprises a major chunk of the expense ratio and can range from 0.5% to 1.0% of the total asset base.
• Administrative Costs These are costs related to the maintenance and administrative services of the fund. Generally, they include costs for recordkeeping, consulting, transactions, accounting, customer support, custodian charges, entry and exit fees of the portfolio assets, legal and audit fees, registrar/audit expenses, information e-mails, communications, etc. All these expenses contribute to a fund’s administrative component.
• 12B-1 Distribution Fee This is an operational expense that goes towards marketing and promoting a mutual fund to increase the asset base. The 12B-1 fee is also charged as commission for advertising, distributing pamphlets, and spreading information among potential clients to raise more money for investment.The 12B-1 fee is just a fraction of the assets under management. It may appear trifling in the initial years but becomes substantial over time due to the compounding effect, which can impact the investment considerably.

The expense ratio states the amount an investor has to pay the mutual fund house towards expenses incurred for portfolio management. Since it is a percentage of the total fund assets, the ratio can have a direct bearing on investment returns. Let’s say a mutual fund has an expense ratio of 2% and makes a profit of 15%.This will translate into a 13% return for the investor. Given that the expense ratio is charged regularly a higher rate may drain your returns due to the power of compounding. In contrast, a lower rate could yield more profitability.

Expense Ratio = [Operating Expenses ÷ Average Value of Fund Assets]

Different funds have different expense ratios. The costs incurred are calculated and published by fund houses in reports once every six months. You, as an investor, can check the fund company’s prospectus, website, or ask your financial advisor for details about these expenses.It helps to be knowledgeable about the asset-weighted average expense ratio for various fund categories. For instance, the expense ratio is a good differentiator between actively managed funds and passive funds. The former charge a higher rate because a professional manager is hired to formulate strategies and make investment decisions daily. The latter, on the other hand, don’t employ fund managers but track the index themselves, which helps save on costs.Regular plans come with a higher expense ratio as they are bought and sold through agents who require a commission for the service rendered. Direct plans, however, bypass intermediaries for any transaction which automatically lowers their operating cost and expenses.When it comes to equity-oriented funds, the expense ratio may not be consequential as they usually provide double-digit returns. The annual fee, meanwhile, is critical in debt funds where every paisa counts as they usually give a comparatively lower return.In some funds, such as Index Funds, which mimic the index, the returns of most funds are similar. Expense ratios in these funds, can hence, become a deciding factor among investors when choosing a fund.

The Securities and Exchange Board of India (SEBI) has laid certain curbs on the expense ratio that a mutual fund can levy on investors’. As per Regulation 52 of SEBI Mutual Fund Regulations, the maximum permissible ceiling for the expense ratio depends on the total assets under management (AUM) of the fund. As the AUM increases, the expense ratio has to decrease proportionately as per SEBI.For instance, equity schemes that are actively managed can charge a maximum of 2.25% for 0 to 500 crores of AUM, whereas the same limit for debt funds is 2% (annualised) of the daily net assets. This keeps on decreasing as the AUM increases. Mutual fund schemes can charge additional expenses if they bring inflows from retail investors in B-30 cities.

Simply put, you must pay close attention to the applicable expense ratio before plunging into an investment fund as it is easy to miss. Remember, a small variation in fees in the initial stage may sound trivial. Still, in due course, the cumulative reduction can destroy returns and make a huge difference to the investment outcome.While the focus on expense ratio is crucial, it should not be the sole criterion for selection. It’s equally important to factor the mutual fund’s track record and the consistency of the profits delivered.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.